Why Not All Investors Are California Dreamin'

Movie star Cary Grant once remarked that a luxurious castle on the California coast was a “great place to spend the Depression.” In a similar vein, investors may find that the healthy office and hospitality sectors in Los Angeles County are good places to ride out the recession.

While Los Angeles and its suburbs are not immune to the paralyzed debt markets or tenants fretting about rising energy prices, the situation could be a lot worse. In contrast to previous economic slumps, the Los Angeles office market is holding firm on both vacancy rates and asking rents, at least for the time being.

The down cycle in real estate has been “unusual,” according to economist Raphael Bostic, a professor at the Lusk Center for Real Estate at the University of Southern California. While the economy has lingered on the borderline of recession, he says, “It's nothing like what we saw in the early 1990s, when thousands of jobs were lost.”

Broker Bob Safai, a principal with locally based Madison Partners, says that the relative strength of today's office market will help see it through this downturn. “The difference between current and past down cycles,” he says, “is that investors are not forced to sell their buildings, and sell them at a loss.” Office landlords in Los Angeles who choose to sell, he adds, are those who want to put them on the market, and discounting is not a factor.

The relatively healthy office market in Los Angeles is not to be taken for granted. To the immediate south in Orange County, vacancy rates are above 13%. When sublease space is added to that figure, the real vacancy approaches 20%. The difference lies in the diversity of Los Angeles tenants, according to economist Robert Bach, chief economist for brokerage company Grubb & Ellis.

“Orange County had a disproportionate number of firms involved in the mortgage industry that have closed their doors and left some empty space on the market,” Bach says. The difference between Los Angeles and its neighboring county, he adds, is a study in contrasts.

The office vacancy rate in Los Angeles County was 8.7%, a full percentage point higher than at the end of 2007, reports CoStar, but still relatively low. The vacancy rate is not expected to climb much further with only a modest amount of new office space coming on line. About 5.2 million sq. ft. is under construction, a 1.3% bump in supply in a market with an inventory of 407 million sq. ft.

The slow pace of new office space adding to the office inventory is probably a good thing given the molasses-like pace of leasing activity, according to Safai. “Deal velocity is down maybe 70%,” says the office broker.

Even with the slower pace of deals, some big leases have punctuated the still air of the recession like beats on a kettle drum. The largest has been a 420,000 sq. ft. lease that Fox Interactive Media signed for two entire buildings at Horizon at Playa Vista, a development of Lincoln Property Co.

In downtown Los Angeles, the law firm of Latham & Watkins has leased 398,000 sq. ft. in KPMG Tower, a property owned by Maguire Partners. Back on the West Side, Belkin Electronics has leased 120,000 sq. ft. in four build-to-suit buildings at The Campus at Playa Vista, a joint venture of Tishman Speyer and Walston Street Capital.

Despite the credit crisis, institutional investors were able to buy office buildings in the past six months. In March, Transwestern Investment Co. paid $125 million for two buildings, 400 and 600 Corporate Point in Culver City. The seller was Arden Realty, a unit of GE Real Estate.

In June, Arden Realty sold six additional buildings in West Los Angeles and the San Fernando Valley to Douglas Emmett Inc. The Los Angeles-based real estate advisor laid out $610 million for the 1.4 million sq. ft. portfolio. An important factor in both sales was the willingness of GE Real Estate to provide debt financing to the buyers.

Yet another notable sale was that of 5055 Wilshire Blvd. The buyer, Somerset Group of New York, paid $45 million for the 170,000 sq. ft. building; the seller was USAA Real Estate Co. of San Antonio, Texas.

Many office investors are not planning to sell, however, citing the likelihood of discounting prices in a climate of hard-to-get debt financing. One cautious landlord is Robert Held, president and CEO of Held Properties, which owns and manages four office buildings in Century City and West Los Angeles.

Held says he does not plan to sell. Anybody who does so, he says, faces considerable financial risk. Held has little faith that the hard times will lift in 2009 or 2010, as some economists predict. “I hope that happens,” he says, sounding unconvinced. Meanwhile, “I have to predict rents and costs for the near future, and commodity costs are so caddywampus right now, I'm just waiting for them to come back into line.”

Condo craze goes cold

In contrast to the washboard abs of the office sector, the condo market is looking decidedly soft and unappealing. The runaway condo market has become a poster child for overbuilding. As in the rest of the country, sales are off and prices have fallen. At the end of June, the median price for an existing condo in Los Angeles was $343,500 compared with $448,550 a year ago, a 23.5% drop, according to the California Association of Realtors.

“Nothing is selling,” says developer Phil Hart, executive director of the Los Angeles chapter of the Urban Land Institute. Some condo developers, he adds, are converting newly built for-sale units to rentals, in contrast to the trend of converting apartments into condos.

In downtown Los Angeles, probably the largest and most overbuilt condo market in the region, at least three for-sale projects have hung “for rent” signs. Those projects include Lincoln Property Co.'s 272-unit Mozaic; the 118-unit Artisan at Second, a project of Trammell Crow Residential; and the 162-unit Chapman Flats, the refurbishment of a century-old office building by local developer Fred Afari.

Despite the weak condo market, some major projects remain under development, assuming that developers can still find financing. In June, the Los Angeles City Council approved the 76-story, $1.3 billion Park Fifth Building, a project of local developer David Houk. Construction on the tower near Pershing Square, originally slated for the first quarter, has been delayed until the end of the year.

In Century City, the high-rise office enclave just west of Beverly Hills, SunCal Cos. plans a 73-story, glass-covered condominium tower called 10000 Santa Monica Boulevard. Designed by French architect Jean Nouvel, the building that its developers have dubbed “the Green Blade” is slender and wide, looking like a giant laptop computer balancing precariously on its edge. SunCal has not announced construction dates.

The Century, a high-priced residential tower in Century City, is under construction on the site of a demolished hotel. The Related Cos. is the developer of the building designed by architect Robert A.M. Stern.

The project recently made headlines when Candy Spelling, widow of TV producer Aaron Spelling, spent $47 million for the entire penthouse floor. At $2,700 per sq. ft., the developers claim the price sets a record for housing in Los Angeles, although some portions of the same building are listed at $2,880.

Mixed-use awaits train

The growth of commuter rail in Southern California is inspiring a set of transit-oriented projects that combine housing with retail and office space. Forming public-private partnerships with government agencies such as the Metropolitan Transportation Authority of Los Angeles County (MTA) makes good sense in recessionary times, according to land-use attorney Elizabeth Watson of Greenberg Glusker Fields Claman & Machtinger based in Century City.

One advantage of transit-oriented projects is that Los Angeles and surrounding cities favor these developments as a means to encourage rail ridership, which argues for a smooth government-approval process. Another advantage is that the transit agency already owns much or all of the land, sparing the developer the time and cost of land assembly.

By entering into a public-private partnership with a transit authority, Watson says, developers “can minimize entitlement risks, while public subsidies can help cushion financial risks.” Several eastern suburbs of Los Angeles, including El Monte and Monrovia, have set aside dozens of acres for transit-oriented housing, retail and office space.

In Los Angeles, where the city council is willing to waive some parking requirements for projects within walking distance of rail stations, “developers can get more leasable square footage because they are devoting less space to parking,” according to Watson. The result, she adds, is a “more economically justifiable project that is easier to finance.” A potential downside of these projects, of course, is that many contain multifamily units — a factor that has caused several projects to be delayed.

One notable public-private project is NoHo Commons, a residential and retail complex in North Hollywood, at the northern terminus of the Metro Rail Red Line. The 60,000 sq. ft. retail portion, including a multiplex cinema, opened this spring, while 870 apartments, including 294 loft units, are being built in phases. The owner is Redwood Partners.

On Sunset Boulevard in Hollywood, another transit-oriented behemoth is the $400 million Avenue 6200, a 1.1 million sq. ft. project of The Clarett Group of New York. In addition to more than 1,000 apartments on the seven-acre site, the developer plans 175,000 sq. ft. of retail space and 40,000 sq. ft. in “live-work” units intended for small entertainment-related businesses. Although Clarett originally planned to start construction last March, the developer has pushed groundbreaking up to January 2009.

The city's most notable mixed-use undertakings arguably are two gargantuan projects that frame downtown Los Angeles like a pair of bookends. On the north is The Grand, formerly known as Grand Avenue, a set of 16 residential towers and 500,000 sq. ft. of retail space being developed by The Related Cos. on publicly owned land.

The developer had to patch together new financing after a major equity investor pulled out, delaying the start of construction for nearly two years. The contract with the public agencies requires Related to start construction by February 2009, or face steep fines.

Downtown's southern bookend is L.A. Live, an entertainment-hotel and condo extravaganza within a short walking distance of the Los Angeles Convention Center and Staples Arena, the city's basketball and hockey venue. Developed by billionaire Philip Anschutz through his Anschutz Entertainment Group, L.A. Live is a set of night clubs and retail spaces surrounding a large courtyard.

The centerpiece is a 53-story hotel tower expected to contain the city's long-awaited convention center hotel to be operated by J.W. Marriott, and 200 condominium units known as the Ritz-Carlton Residences scheduled for completion next year. The most recent portion to reach completion is the metal-clad, 7,000-seat Nokia Theater.

Biggest hotel sale in the U.S.

Hospitality is another bright spot amid the gray skies of recession. Although occupancy in May fell nearly a full percentage point from a year earlier to 76.6%, revenue per available room (RevPAR) rose 4.9% during the same period, according to the Los Angeles County Economic Development Commission. RevPAR in Los Angeles hotels, in fact, has increased every month since 2003.

The strength of the hotel market reflects the popularity of Los Angeles with both European and Asian tourists, primed by the weakness in the U.S. dollar, which makes American vacations a bargain for international travelers, according to Troy Jones, a partner in Ernst & Young's office in downtown Los Angeles.

One recent high-profile deal was the $366.5 million sale of the 726-room Century Plaza Hotel to a partnership of Next Century Associates and D.E. Shaw. The seller was Sunstone, a REIT based in San Clemente, Calif. The deal was “the only hotel sale of any significance in the past half year in Los Angeles, and possibly in the entire country,” says Jones. Much of the price reflects the scarcity of hotel rooms in Century City, the largest office enclave in the West Los Angeles area, he adds.

Meanwhile, in the coveted Beverly Hills hotel market, the $200 million, 201-room Beverly Hills Montage hotel is nearing a fall 2008 completion. The project survived a ballot-referendum challenge in 2004 brought by surrounding hotels, which sought to derail the project by popular vote. The developer is Phoenix-based Athens Group. The hotel operator, Montage, is a company whose largest investor is Pierre Omidyar, founder and chairman of eBay.

Where's the bottom?

Despite a smattering of high-ticket property sales, however, investment activity is quiet in Los Angeles. Bostic, the USC professor, says that there is plentiful capital waiting to enter the market for commercial real estate as soon as the investment community is convinced that property values will fall no further. “The interesting question, and I don't have an answer for it, is when investors decide that the market has hit bottom,” he says. At that point, he adds, capital is likely to rush back into the Los Angeles market.

One prediction Bostic is willing to make, however, is that the bubble mentality of the early 2000s will be replaced by a more cautious and conservative approach to valuation. “We will see more consideration of the underlying fundamentals of these assets, and whether prices and valuations make sense, given the cash flows.”

Nobody, of course, knows how much of a hit Los Angeles real estate will take by the time the recession is over. The strength of fundamentals — limited supply, steady demand, and sustained interest from institutional investors — suggests that the Los Angeles market will start the next business cycle without too much excess space to shed.

Morris Newman is a Los Angeles-based writer.

LOS ANGELES - BY THE NUMBERS

LARGEST PRIVATE EMPLOYERS

Kaiser Permanente32,180 employees

University of Southern California26,446 employees

Northrop Grumman Corp.21,000 employees

Sources: Los Angeles Almanac, L.A. Business Journal

REGIONAL Population: 10.36 million

Source: Los Angeles Almanac

UNEMPLOYMENT RATE: 7%

Source: The Kyser Center for Economic Research

METRO AREA VITAL SIGNS

Office:

8.7% vacancy, 2Q 2008

7.4% vacancy, 2Q 2007

$31.31 rent per sq. ft., 2Q 2008

$29.31 rent per sq. ft., 2Q 2007

Source: CoStar

Multifamily:

4.2% vacancy, 2Q 2008

3.4% vacancy, 2Q 2007

$1,408 effective rent, 2Q 2008

$1,347 effective rent, 2Q 2007

Source: Marcus & Millichap

Retail:

3.4% vacancy, 2Q 2008

2.7% vacancy, 2Q 2007

$27.37 rent per sq. ft., 2Q 2008

$26.83 rent per sq. ft., 2Q 2007

Source: Reis

Industrial:

2.16% vacancy, 2Q 2008

1.8% vacancy, 2Q 2007

$0.70 rent per sq. ft., 2Q 2008

$0.66 rent per sq. ft., 2Q 2007

Source: CB Richard Ellis

Hotel:

78.5% occupancy, 2Q 2008

80% occupancy, 2Q 2007

$131.93 average daily rate, 2Q 2008

$123.94 average daily rate, 2Q 2007

Source: Smith Travel Research

MAJOR PROJECTS

L.A. LIVE: A 4 million sq. ft. sports and entertainment development within walking distance of Staples Center and The Los Angeles Convention Center in downtown Los Angeles centering on a 878-room J.W. Marriott hotel. The project features a mix of entertainment venues, restaurants, retail and residences, plus television and radio broadcast studios and concert spaces.

Developer: Anschutz Entertainment Group

Completion: Fall 2008

Cost: $1.5 billion

AMERICANA AT BRAND: A 900,000 sq. ft. shopping center that features imaginative architecture in Glendale, Calif., and combines high-end retail, housing and entertainment. This project is designed to re-energize the downtown with 75 shops and fashion boutiques along with cause and fine dining in an outdoor setting. The residential portion of the development features 238 luxury apartments and 100 luxury condominiums.